The passive loss rules prevent losses from investment activities where the taxpayer is merely “passively” involved from offsetting income that the taxpayer actively “materially participates” in earning.
Normally, a person can deduct one’s losses against his or her income. But there are some restrictions on this. Several years ago, in the 1980s, individuals who had large amounts of income would attempt to offset that income by investing in businesses that typically generated tax losses but still produced positive cash flow. For example, they would invest in real estate businesses (partnerships) so they could take non cash depreciation deductions along with interest deductions, and property taxes among others. Essentially, these types of investments served as a tax shelter—allowing the investor to offset their income (from other sources) by all their losses from the investment activity. (In this context, a tax shelter is an investment where a significant part of the taxpayer’s return is derived from the realization of tax savings along with appreciation of the underlying asset overtime).
Congress responded to this tax shelter strategy by enacting IRC § 469. Before 1986, there were few limitations placed on a taxpayer’s ability to utilize deductions from one activity against the income from another activity. Today the application of these rules is very broad.
a. Which taxpayers are subject to the passive loss rules?
The passive loss rules apply mainly at the individual (1040) level. However, these rules effect the deductibility of flow though losses to partners of partnerships and shareholders of S corporations. They also apply to losses from trusts, estates, and personal service corporations.
A taxpayer who owns an interest in an activity as a limited partner or member is not treated as materially participating in the activity by definition.
b. What is a “passive activity”?
Generally, a passive activity is any activity that may be considered an investment or a trade or business that the taxpayer does not “materially participate” in. Material participation means that a taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. The participation level is determined on an annual basis and the regulations under code 469 spell out what requirements are necessary to be considered to have “materially participated in an activity.”
Passive activity expenses and losses are those expenses and losses attributable to passive activities that generate income. Such expenses and losses can generally only be used to offset income from passive activities. Expenses and losses that exceed passive activity gross income may be carried forward until such excess is used up or offset against any gains on the disposition of a passive activity. Passive activity gross income includes gain from the disposition of property used in a passive activity at the time of the disposition.